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Who Invented TBTF (Too Big to Fail)?

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The tangled history of an idea nobody loves.

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Most controversial issues have people on both sides, and we know more or less why they disagree. People who want more gun control think it will reduce violence and fear. People who don't want more gun control think it will lead to more crime and government disrespect for citizens. We can trace the history of the dispute and find people on both sides of the issue.

TBTF (too big to fail) is different. Everyone is against it. Everyone agrees that institutions insulated from failure behave recklessly, and that government supporting the big firms in an industry creates a tilted playing field that discourages innovation, independence, and human-scale institutions. It's expensive, threatening to bankrupt many governments. It's revolting to witness governments bailing out big banks - the ones with those extortionate overdraft fees and deceptive credit card charges - and rich people while raising taxes and cutting programs to pay for it. Private profits and socialized losses offends our sense of fairness as it robs our wallets.

So why are we stuck with this unloved idea? Most people have a vague sense that the banks grew big while regulators weren't paying attention, until one day we woke up and discovered some were so big that their failures threatened the economy. If anyone had any doubts about this, the disaster following the Lehman bankruptcy proved it, and Lehman was only the twelfth largest bank in the US. But if that's true, why haven't we broken up the large banks? The answer to that question is that TBTF has an entirely different history that you have to understand in order to see what the future is likely to bring.

The story begins in 1984 with the failure of Continental Illinois Bank. The seventh largest bank in the US at its peak, it had made many imprudent business loans, especially to oil and gas companies hurt when energy prices declined, and overpaid for some acquisitions (notably Penn Square Bank) that had made even worse loans. It had some other bad exposures to developing countries and it guessed wrong about interest rates. As a result, the government had to take it over. The good news is that CI didn't have a lot of insured deposits; it funded itself mostly by taking brokered deposits too large to be covered by FDIC insurance, and by issuing notes and bonds. Another bit of good news is that it had a pretty simple corporate structure and balance sheet.

There are two basic ways to resolve a failed bank. The simplest way is to shut it down, auction off the assets, and pay off the creditors in order of seniority. If there isn't enough to cover the insured deposits, the FDIC writes a check for the difference, and if necessary, raises the insurance premium on other banks to recoup the loss.

The downside of that approach is that you sacrifice the going concern value of the bank. In addition to the assets on the balance sheet, a bank has value due to its branch network and business relationships. Perhaps the assets would fetch $50 million less than the liabilities at auction, but another bank is willing to absorb that $50 million loss in order to acquire the intangible assets of the bank. Moreover, the failed bank's assets will always be worth more to a financial institution experienced at managing distressed loans than the assets will fetch at auction.

So the second way to resolve a failed bank is to find another bank willing to take it over, possibly with some cash thrown in by the government - but less cash than a liquidation would cost. Not only does that save the FDIC money, but it also means less turmoil among bank customers, counterparties, and employees. However, there is a downside to this as well: It takes longer and is more complicated than a liquidation, and the government has to support the failed bank while searching for an acquirer.

Traditionally the government would opt for a liquidation unless a willing acquirer could be found before the troubled bank failed. But twice before CI, the FDIC had supported a failed bank by guaranteeing all creditors - not just the insured depositors. That was a risk; if the bank had to be liquidated anyway, the government was on the hook for a larger loss. The potential reward was that the extra time bought by the guarantee would be enough for a win-win deal to be structured. In both of the first two instances, the gamble paid off.
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